By Eric Teo – Head of International Practice & Special Projects
What are the questions to consider if an employer wishes to pay directly to a subcontractor – bypassing payment to its main contractor but without taking over the liability of the subcontract? Lately, I have received an increasing number of enquiries concerning such a situation. The increase could be a sign of the COVID-19’s impact on the UAE’s construction industry, exposing the precarious position of those main contractors who are facing serious liquidity issues.
Paying subcontractors directly indeed has its own set of risks. But some employers might see this as an option if there is a low risk of the main contractor retaliating by suspending work, or perhaps the project has reached a completion stage where it no longer requires the main contractor’s active participation.
It is always a big concern for the employers when their main contractors do not have the cash flow to pay subcontractors on time or at all, this could jeopardise the completion of the projects (and may also affect work quality). And for subcontractors, there is a heightened risk under the current economic climate that they might not get paid despite the employers’ payments to their main contractors. On top of the “back to back” payment clause in subcontracts, which is prevalent in the UAE subcontracting market, the main contractors’ liquidity is an extra risk that subcontractors cannot afford to accept (see my take on the use of “back to back” payment clauses).
The General Legal Position
Before turning to the questions or potential issues, we should take note of the relevant provisions of Articles 890 and 891 of the UAE Civil Code (Federal Law No.5 of 1985). Article 890 provides that the main contractor may employ subcontractors to carry out part of the works so long as there is no condition in the main contract that prevents it from subcontracting. It further provides that the main contractor will remain liable to the employer for the works.
Whereas Article 891 prevents a subcontractor from claiming directly from the employer for monies payable to the main contractor unless the main contractor assigns its dues under the main contract to the subcontractor. In practice, the main contractor’s freedom to assign is restricted under the main contract as the employer’s prior consent is often a precondition. And rarely would an employer be willing to consent to such an assignment that would expose it to potential actions by the sub-contractor.
We also need to appreciate that there are generally two kinds of subcontractors, i.e. the domestic subcontractor and the nominated subcontractor. A nominated subcontractor is chosen by the employer who would then enter into a subcontract with the main contractor. Very often, the commercial terms of the nominated subcontract are negotiated only between the employer and the subcontractor. The employer would then instruct the main contractor to accept the terms as agreed with the nominated subcontractor.
In the situation of a nominated subcontractor, the provisions of the main contract may allow the employer the right to make direct payment to the subcontractor under certain conditions without the risk of creating any privity of contract between employer and nominated subcontractor. This kind of direct payment arrangement (for example, Sub-Clause 5.4 of the 1999 FIDIC Red Book Contract) is unlikely to circumvent the prohibition of Article 891 referred to in the above because it does not expressly allow the nominated subcontractor the right to demand payment directly from the employer. Moreover, such payment arrangement is created only for the benefit of the employer, who has the sole discretion whether or not to exercise the right to make a direct payment.
The General Position Can Change
Through the wordings of their contracts and sometimes by their conduct, the three parties can, deliberately or otherwise, interfere with the general positions provided under Articles 890 and 891. What this means is that other types of legal relationship may exist alongside those created under the main contract and subcontract. For instance, a party could owe a responsibility to another party even though there is no direct contract. Therefore, the following list of documents and exchange of communications between the parties should be carefully examined for their legal implications:
- The terms of the main contract between the employer and the main contractor.
- The terms of the subcontract between the main contractor and the domestic subcontractor or nominated subcontractor.
- The terms of any collateral warranty or guarantee provided by the domestic subcontractor or nominated subcontractor to the employer including any direct assurance given by the nominated subcontractor.
- The terms of the tender conditions and tender offer that the nominated subcontractor submitted to the employer, and any letter of acceptance that the employer (or its representative) might have issued to the nominated subcontractor.
- The terms of the letter of nomination of a subcontractor issued by the employer to the main contractor.
- The exchange of communications between the employer, the main contractor and the nominated subcontractor during the negotiations of the nominated subcontract.
With the above points in mind, the following are the questions that all three parties should consider:
- Can the employer pay directly to the subcontractor without the main contractor’s consent if there is no mechanism in the main contract for direct payment to subcontractors, or if the preconditions of such mechanism are not satisfied?
- In continuation of question 1, would the employer’s direct payment and the subcontractor’s acceptance of that payment each constitute a breach of contract under the main contract and subcontract respectively? If it would, then what kind of damages could arise from these breaches?
- Can the subcontractor pursue the employer directly if the latter fails to make further direct payments for the completed subcontract works? And can the subcontractor also pursue compensation payment for any disruption or prolongation of the subcontract works that it might have suffered?
- Can the employer insist on paying the subcontractor even if the main contractor asserts that the subcontractor has been overpaid because there is an over-certification of the value of the completed subcontract works and/or the main contractor has a claim against the subcontractor for back-charges, delay penalties or general damages?
- Can the main contractor rely on the direct payments made to the subcontractor to release itself from any responsibility or liability if the subcontractor fails to perform after receiving direct payments from the employer?
- In the absence of any collateral warranty or guarantee from the subcontractor, can the employer pursue the subcontractor directly for defective works and other kinds of non-performance?
- If the subcontractor is wound-up or bankrupt, can the employer recover the equipment or materials that it has paid to the subcontractor but had not been delivered to the project site?
- What happens if the main contractor goes into receivership or bankruptcy proceedings? Can the receiver or liquidator recover the direct payments or general damages from the employer and/or subcontractor?
The above list of questions is by no means exhaustive given that each situation will differ according to the wordings of the contractual documents and the factual matrix between the parties. However, the list can be used as a starting point to consider other potential issues that might arise so that they can be properly dealt with in a negotiated assignment or novation of the subcontract.